Comparing compensation: state- local versus private sector workers
The comparability of state-local versus private sector pay has become a major issue in the wake of the financial crisis. Funded levels of public pension plans declined sharply, and governments’ ability to make required contributions has been severely constrained by the collapse of state-local budgets. Politicians everywhere are looking for ways to reduce pension costs and increase revenues. Often such efforts are couched in terms of excessively generous existing compensation – especially, current pensions.
Dueling studies have appeared arguing that state-local workers are paid less or more than their private sector counterparts. Virtually all agree that wages of state-local employees are lower than for private sector workers with similar education and experience, but researchers differ on the extent to which pensions and other benefits compensate for the shortfall. This brief builds on the recent wave of studies by refining the estimates of the value of benefits.
The discussion proceeds as follows. The first section presents some basic data on wages and benefits. The second section, following the methodology of earlier researchers, estimates the relative wages in the state-local versus private sector, controlling for education, demographics, and other factors. The results suggest that state and local workers in the aggregate have a wage penalty of 9.5 percent. The third section explores the extent to which benefits for state and local workers offset the wage penalty. With appropriate modifications for pension contributions and the addition of retiree health insurance, annual public sector compensation – including both wages and benefits – is about 4 percent less than that in the private sector. The final section concludes that, given the modest size of any differential between public and private compensation, policymakers should look carefully at the specifics of their own state or locality before making significant changes.
Academics and policy-makers often overlook that Social Security rules are interlinked with the age profile of productivity and earnings over workers' careers. We show in this paper that these two characteristics of the economy are part of the same general equilibrium. In fact, the age at which an agent chooses to retire depends on his stock of human capital in so far human capital determines their productivity in the labor market. The reason is simple: the higher is human capital, the higher is labor income, and so the smaller is the incentive to retire. Since, in general, people differ in their ability to acquire and maintain human capital, less productive individuals retire in disproportionate number from the labor force. But this observation is not enough to rationalize the starkly diffierent behavior in retirement decision across workers in different European economies. The crucial observation we make here gives a central role to the level of social security taxation. In the empirical evidence we present regarding European countries, we highlight that the average retirement age tend to be lower in countries where social security taxes are higher and the labor market, including the private sector, rewards relatively more seniority.
We propose a general equilibrium perspective to systematically rationalize these features. The intuition is the following. In economies where the social security tax is high, the private beneift of human capital accumulation are reduced while the Social Security benefits tend to be large and the early retirement age tends to be low. Then only the most productive individuals and it convenient to remain workers because their high human capital commands high wages.
The selection among workers is reflected in the average wage observed among more senior workers and in the aggregate the labor market displays a more pronounced seniority premium. As a consequence of high social security taxation and the resulting low investment in human capital, the aggregate effective human capital is reduced, labor income stays stagnant and, on average, individuals retire earlier. While the age profile of wages is increasing for economies with high social security tax, this is not the case, by a specular reasoning, when social security taxes are low. In these economies even low productivity individuals and it convenient to accumulate more human capital and remain active in the labor market for longer periods. In this latter group of economies the average wage by age class follows the dynamic of individual human capital: it first increases and then it decreases in the second half of the working career. The age profile of wages takes a more hump-shaped structure and the seniority premium falls.
This study has two main contributions, both a theoretical and an empirical one, relating Social Security rules and the age profile of wages. First, while we are certainly not the first to observe that Social Security in general and the level of social security taxation in particular affects the accumulation of human capital and retirement decision, especially among the least productive individuals, (Conde-Ruiz et al., 2005, Conde-Ruiz and Galasso, 2003, 2004), this is to our knowledge the first paper to link it the shape of the age profile of earnings to SSSs and to highlight how these profiles differ among European countries in terms of the seniority premium.
Differently from the seminal contribution of Lazear (1979), we show how these differences do not necessarily reflect discrepancies between the wage and individual productivity. Establishing this link is not just an intellectual curiosity, but it is an important observation for policy. As SSSs enter additional distress because of the aging population, policy reforms point in the direction of increasing the level of social security taxation, possibly in alternative to an retirement age increase. As we point out in this paper, policymakers should be particularly wary of taking this view because raising social security taxation not only decreases human capital, but it also has the effect of making individuals, especially but not only the low productivity ones, less eager to remain in the labor force. We also provide an empirically valid measure of the severity of this phenomenon: the seniority premium observed in the labor market.
The first part of the paper develops a general equilibrium model to help to systematically tie together the age profile of earnings and Social Security. The second part provides cross- country evidence supporting the view that there is a robust empirical relationship, within European countries, between high Social Security taxes, low investment in human capital, labor markets that reward more seniority, early retirement and low labor market participation at old age.